Dollar-euro madness

Dollar-euro madness





Richard W. Rahn


October 24, 2007




Do you care about the fall of dollar against the
euro? This article explains why you should care and what might be done
about it.
In 2001, a Spanish family living in Barcelona and
an American family living in Orlando had very similar homes of equal
value. That year, they each bought a BMW 5 series car and paid the same
price. Now six years later, each family has experienced a 30 percent
appreciation in home value, and the automobiles are only worth
one-third of the amount paid for them. Yet the Spanish family's home
and car are now worth 40 percent more than the American family's home
and car. The Spanish family appears to have gotten a lot richer than
the American family, all due to the rise in the euro against the dollar.
As
you can see in the accompanying chart, the dollar and the euro have
widely fluctuated against each other for the last decade, the euro
falling roughly 40 percent against the dollar from 1999 to 2001 and
then rising roughly 60 percent since.
If the above mentioned
Spaniards decide to sell their home in Spain and move to or travel to
Florida, they can now buy a much nicer home for the same money; while
if the Floridians decide to move to or travel to Spain, they will have
to pay more or downsize. Note: neither the Spaniards nor the Americans
did anything to change their relative wealth circumstances; they were
solely at the mercy of government policymakers and currency speculators
like George Soros.
These rapid and extreme currency value
shifts wreak havoc with manufacturers in all the affected countries. If
you were a European automobile manufacturer and had to decide in the
year 2000 where to build a new assembly plant to serve the American
market, you might well have concluded to build it in Europe because of
the low value of the euro at that time. But now in 2007 many of your
relative costs may be a third higher than anticipated. These exchange
rate movements swamp tariff and other tax concerns, and often cause
manufacturers and those in the tourist industry to lose money.
The
exchange rate movement implies that the whole physical stock of Europe
(land, buildings, machines, art, etc.) is suddenly worth 40 percent
more in dollar terms than it was six years ago — and this of course is
nonsense, given there has been no drastic difference in the performance
of the relative economies in the last six years. The problem comes from
the fact that currencies, like commodities, are priced at the margin —
that is, how much it costs to obtain one additional unit, not the
average cost of the entire stock. If every item in Europe had been put
up for sale for dollars, in total it could not sell for 40 percent more
today than in 2001, unless the supply of dollars had grown 40 percent
faster than the supply of euros, which it has not.
Many
economic commentators argue that the dollar has fallen relative to the
euro largely because of the U.S. trade deficit, and must fall further
to rectify it, even though the United States has been running a trade
deficit for years. In fact, it has been the desire of foreign
governments, companies and individuals to buy dollar assets, such as
U.S. government bonds, which has caused the trade deficit. For them to
obtain dollars to invest in the U.S., they must sell us goods and
services.
A non-American who believes the dollar will
continue to fall is likely to curtail purchases of U.S. financial
assets, but at some point the products and real assets of the U.S.
(real estate and operating businesses) will look so cheap to Europeans
that they will trade their euros for dollars to buy these cheap
products, hotels, manufacturing plants and homes, and the dollar will
begin to rise. When the dollar begins to rise, it is likely to cause
the belief that not only real assets are undervalued but also financial
assets, and the pendulum will swing in the opposite direction.
Agricultural futures markets, which enable price hedging, were
initially established well more than a century ago to mitigate wide and
destructive price swings in corn, wheat, etc. There was little need to
have futures contracts with expiration dates more than a year in the
future, given that both farmers and processors of agricultural products
could protect themselves from price fluctuations over the growing
season.
Part of the solution of destructive currency price
swings is to develop currency futures markets with expiration dates
much longer in the future, perhaps even 10 years, than the current
widely traded contracts, which are mostly a year or less. This would
enable those in the manufacturing, tourist and other severely impacted
industries to protect themselves from exchange rate swings, outside
their control.
In addition, very long-term currency contracts
would provide government economic policymakers with cues about what
they were doing correctly or incorrectly.
Richard W. Rahn is the chairman of the Institute for Global Economic Growth.